...AND TO CONTINUE

We talked last week about how it was that everything went so badly wrong and promised to discuss what might be done to prevent such a mess from occurring again. In regard to CDSs, the solution (if there is one) might be fairly simple and one without a good deal of disagreement. What set the dire events in motion was the total lack of knowledge on the part of the participants as to the volume of the market and the exposure of the individual participants, not only in aggregate but to one another. There were intelligent and in some cases accurate guesses to be sure, but real time information was woefully lacking due to the fact that there was no central body through which transactions were cleared; the business was conducted as they say in the trade in an over-the-counter market...companies delt directly with other companies directly on their own books with no one keeping score.

CDSs were considered by some (many?) to be just another derivative--a creation whose value is based on something else. Derivatives have been around for some time starting with simple interest rate swaps--you pay me a steam of money on a fixed rate basis and I pay you a stream...based on the same principal amount...on a floating rate basis and VOILA, we have created a fixed rate obligation out of a floating rate one thereby transforming the underlying debt into one or the other. Cleaver and useful, no? Now there is a chance that on side may get it wrong and pay a floating rate during a period of rapidly rising interest rate but the loss suffered will never be the principal amount; it will only be the difference in the cost of money during the period that the transaction is outstanding which in most cases will be only a small percentage of the nominal amount. Not so with Credit Default Swaps. That, my friends, can be a zero sum game for if the underlying obligor defaults, the loss can be 100% for the poor slob who wrote the contract.

AIG and others wrote A LOT of contracts about which no bod ee knew nuttin'. Think of the different result if all of there transactions would have been through a central clearing house. Three things would have been accomplished:

1. Counterparties would have been revealed
2. Outstanding exposures would have been revealed
3. There would have been a hell of a lot fewer contracts written due to the now-revealed exposure which would have tempered the zeal for dealing with companies that were perceived as becoming overexposed

I suspect there will shortly be a clearinghouse for transactions of this type, as there should be, for there is very little disagreement among regulators as to its need.

As to other forms of derivative transactions, there seems to be apparent agreement among regulators around the world that some additional forms of control are required. However, there is yet to be agreement as to who the regulators are to be and how the regulation is to be accomplished. If the institutions involved are banks, the control is fairly simple: bank regulators have long controlled the businesses in which banks participate through reserve requirements; take this risk and you have a reserve requirement of x; do that, x + y; do THAT, (x + y)2. But if they are not banks like AIG? Ah ha, a subject for another day as well as a discussion on rating agencies.